Fiscal Consolidation: How much, how fast and by what means?

12/04/2012 - The economic crisis that began in 2008 caused government deficits to surge and pushed public indebtedness to 100% of GDP for the OECD as a whole in 2011. In many countries, just stabilising debt, let alone bringing it down to a sustainable level, will be a major challenge. The poor state of public finances will require wide-ranging fiscal consolidation in most countries, particularly in those whose pre-existing imbalances have been aggravated by the crisis, as well as in those facing rapidly rising spending on health and long-term care.

Bringing debt down to prudent levels will require sustained fiscal consolidations of more than 3% of GDP in many, though not all countries. Some countries must anticipate extremely large efforts: Japan faces fiscal tightening of up to 12% of GDP, while consolidation in the United States, the United Kingdom and New Zealand is projected at more than 8% of GDP (see figure below, access the data In Excel).

How much consolidation is needed?Immediate rise in the underlying primary balance needed to bring debt to 50% of GDP in 2050

In the short term, the pace of consolidation needs to be balanced with the effects of fiscal retrenchment on growth. The trade-off will depend on the choice of fiscal instrument, the size of the multiplier (which is highly uncertain) and whether monetary policy can offset the adverse demand effect. Even so, other things being equal, slower consolidation will ultimately require more effort to meet a given debt target.

Given the currently high level of taxation in many OECD countries, which adversely affects economic performance, and the future spending pressures due to population ageing, a large part of consolidation should probably focus on cutting public spending and addressing the drivers of future spending pressures. In countries where spending is low, greater emphasis may have to be put on revenue measures.

Countries can reap sizeable budgetary benefits – both directly and indirectly, through growth-generated fiscal gains – by adopting “best practices” for health and education spending and pursuing pension reforms. Governments can also reform transfer programmes, to rein in spending on often poorly-targeted social benefits and to sharpen incentives to work and save.

On the revenue side, governments should concentrate on limiting tax-induced distortions that are detrimental to growth, notably by broadening tax bases. Governments should also emphasize less-harmful taxes, such as those on immobile property, and corrective taxes, such as pollution charges.

Indicative estimates of budgetary gains from spending and revenue measures, which have little adverse effect on growth, suggest that countries could achieve consolidation of 7% of GDP on average from the cumulative impact of spending and revenue measures. However, flanking measures to cushion the blow to those most exposed to additional hardship will add spending, and thereby offset some of the potential budgetary gains.